Preventing another financial fire

The global financial crisis has inspired people to think of protections for the future, but it seems convincing people to study prevention methods is less enticing than analyzing the catastrophe

By Robert Shiller

The answer, he said, is complicated; but, at least in the US, one serious problem looms large: the US Internal Revenue Service’s refusal to issue an advance ruling on how such risk-managing arrangements would be taxed. Given the resulting uncertainty, no one is in a mood to be creative.

Meanwhile, there is strong public demand — angry and urgent — for a government response aimed at preventing another crisis and ending the problem of “too big to fail” financial institutions. However, the political reality is that government officials lack sufficient knowledge and incentive to impose reforms that are effective but highly technical.

For example, one reform adopted in the US to help prevent the “too big to fail” problem is the risk retention rule stipulated by the 2010 Dodd Frank Act.

In order to ensure that mortgage securitizers have some skin in the game, they are required to retain an interest in 5 percent of the mortgage securities that they create — unless they qualify for an exemption.

However, in another paper presented at the session, Federal Reserve Bank of Boston senior economist and policy advisor Paul Willen said that creating such a restriction is hardly the best way for a government to improve the functioning of financial markets.

Investors already know that people have a stronger incentive to manage risks better if they retain some interest in the risk. However, investors also know that other factors may offset the advantages of risk retention in specific cases. In trying to balance such considerations, the government is in over its head.

The most fundamental reform of housing markets remains something that reduces homeowners’ overleverage and lack of diversification. A separate session paper returned the idea of the government encouraging privately issued mortgages with preplanned workouts was, thereby insuring them against the calamity of ending up underwater after home prices fall. Like housing partnerships, this would be a fundamental reform, for it would address the core problem that underlies the financial crisis. However, there is no impetus for such a reform from existing interest groups or the news media.

One of the discussants, Federal Reserve Bank of New York executive vice president Joseph Tracy — co-author of Housing Partnerships — said: “Firefighting is more glamorous than fire prevention.”

Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending.

Robert Shiller is a professor of economics at Yale University and was the Nobel laureate in economics last year.